BARBARIANS AT THE MALL

A few years ago, Stanley Eichelbaum began experiencing a major case of déjà vu. Eichelbaum, president of Cincinnati-based property consulting firm Marketing Developments, Inc., watched uneasily as private-equity investors began to swarm over the retail business. To him, it looked a lot like the leveraged-buyout boom of the 1980s, which left a trail of bankruptcies and empty stores.

“We issue a regular list of concerns to clients and for the last three years, on top of that list has been the issue of non-retail control of retailers and the havoc that has created in the past,” Eichelbaum says.

Lately, however, he has taken a less alarmist view. Even as the pots of private equity swell and investors are rumored to be circling such retail icons as Gap Inc. and Pier 1 Imports, Eichelbaum, has come to view these investors as badly needed change agents.

“In the past, a buyout meant the retailer was headed for extinction,” Eichelbaum says. “But we have changed our perspective. This group of investors seems intent on rebuilding the industry in a way that retailers were not willing to do for decades.”

It's easy to understand why Eichelbaum was alarmed. Since January 2005, there have been 94 deals in which private-equity partnerships bought retail chains. The total value is $54.8 billion, according to Dealogic, and includes such icons as Lord & Taylor, which was sold by Federated Department Stores to a partnership of National Realty & Development Corp. and Apollo Real Estate Advisors for $1.2 billion. Bain Capital and the Blackstone Group are waiting to finalize their $6 billion purchase of arts and crafts seller Michaels Stores, Inc. Meanwhile, for the second time in the past six years Texas Pacific Group and Leonard Green & Partners are buying PETCO — this time for $1.8 billion.

But, Eichelbaum says, in these transactions he no longer sees the pattern of the 1980s, when financial buyers took over retail companies, leveraged them up and then failed when they could not create sufficient cash flow through assets sales and cost cuts. For the most part, the current buyout firms have shown both an interest in retail operations and seem intent on improving business performance. For example, Mervyns, which seemed slated for extinction, has thrived under its new owners.

Back in the 1980s, the private-equity players were leveraged buyout “raiders” like the oil patch's T. Boone Pickens and Henry Kravis, who engineered the $9.6 billion leveraged byout of RJR Nabisco, which was immortalized in the era-defining Barbarians at the Gate. In retail, real estate mogul Robert Campeau swooped down from Canada to acquire Federated Department Stores and Allied Stores. By 1989, he was unable to keep up with payments and lenders refused to refinance his $11 billion debt. In January 1990, he put Federated into bankruptcy — the event that is credited with ending the 1980s LBO era. When the dust cleared, venerable chains such as Abraham & Straus, B. Altman, Bonwit Teller, Bamberger's, Davison's, Gemco and Ohrbach's were gone.

What's different now? For one thing, today's buyers have been more careful about leverage, says Todd Hooper, a strategist with global consulting firm Kurt Salmon Associates, which has represented buyers on several retail acquisitions. Hooper says that his clients are putting up 30 percent to 45 percent of the total transaction cost, compared with the 10 percent or 15 percent that LBO raiders put up two decades ago.

Another important factor is the low valuations of retailers, says Craig Johnson, president of New Canaan, Conn.-based research firm Customer Growth Partners. Chains like Gap, The Borders Group, Pier 1 and teen apparel seller Hot Topic trade at price-per-earnings ratios of between $13 and $16 per share. Gap shares have tumbled from $34.91 at the beginning of April to $23 in mid-August. Pier 1's share prices have fallen by half, from $12.58 on April 6 to $6.10 in late August.

“We think because the street in general thinks that the consumer is going to tank, retail valuation is down,” Johnson says. “And smart money, like Texas Pacific Group, Bain Capital and Warburg Pincus, are thinking that this is a great opportunity to buy something at very favorable valuation.”

Retail is only one of several tempting targets for these investors, who have raised hundreds of billions of dollars and are scouring the globe for deals. The biggest deal since the barbarians' era is now in the works — a $33 billion buyout of hospital giant HCA by a group of private-equity firms including Kohlberg Kravis & Roberts. Bank of America predicts that the volume of corporate buyouts is expected to exceed $1 trillion in 2006.

Like the old LBO crowd, these investors look to make above-average returns — usually in the range of 15 percent to 20 percent annually — by “unlocking” hidden value. By removing companies from the glare of the public market and the demands for consistent quarterly profit growth by shareholders, these investors (in theory) can more easily undertake massive restructurings and pursue whole new strategies. They usually have relatively long-range time horizons — of about five to seven years — for turning businesses around, before selling them.

The top private-equity players certainly look like patient capital compared to hedge funds. According to Bank of America, hedge funds typically hold assets for only 10 to 18 months, betting more often on changes in market valuations or asset sales, rather than operational improvements.

Retailers are closely monitoring Sears Holdings, the combination of Kmart and Sears engineered by hedge fund ESL Investments, to see how this rare hedge fund deal in their industry plays out. So far, ESL and Sears Holdings Chairman Eddie Lampert has focused on operations and — contrary to expectatations — has not cashed in on the chains' highly appreciated real estate assets

The industry is also watching the private-equity firms that pop up again and again in retail deals — Bain Capital, Texas Pacific, Warburg Pincus, Blackstone Group, Sun Capital Partners and others. They all have long track records in buying retailers, holding on for a few years, building up profitability and getting out by taking the retailers public or selling to another investor.

Texas Pacific and Leonard Green, the team that just struck a deal to purchase PETCO, have already proven their skills with the same company. In October of 2000, they bought the pet-supply store for $600 million, at a time when its annual revenues were $990.3 million. When they took it public, with a valuation of more than $1 billion, in 2002, revenues were up to $1.3 billion. And when Texas Pacific and Leonard Green sold the last of their stock in 2004, annual sales hit $1.65 billion, an overall increase of 67 percent. With PETCO once more feeling the squeeze — from rival PetsMart and discounters Wal-Mart and Costco — the investors are looking for a repeat performance.

Former Target subsidiary Mervyns has rallied under private ownership. When Sun Capital Partners, Cerberus Capital Management and Lubert-Adler and Klaff Partners bought the mid-market department store chain for $1.2 billion in July 2004, it was widely believed investors were interested primarily in its real estate. The firms did close more than 60 underperforming stores, but they also brought in Vanessa J. Castagna, formerly of JCPenney and Wal-Mart, as chairman. Castagna has broadened product selection, brought in more private labels and expanded profitable departments in an attempt to put the retailer back on track.

The value of real estate

Indeed, the new private owners can affect the retail real estate industry in two ways — in how they improve the performance of the chains they buy and in how they handle the real estate portfolios.

The high value of retail real estate certainly plays a role in the deal math; in some cases, like Sears, the estimated value of real estate the chains own or lease is actually greater than the company's total market capitalization. The same is true for Dillard's, an oft-mentioned buyout target.

A lot of mall-based retailers are sitting on undervalued leases and can make a profit by turning the property over to the developer or subletting it to another chain.

In some cases retailer real estate value has created incentive for developers to try and buy back space from struggling anchors. Simon Property Group, Macerich Co. and Westfield Group have all acquired excess stores from Federated this year.

If the vacancy is inside a mall, the owner might divide it into smaller portions and rent it out to several businesses. If it's a freestanding location in a downtown area, like the 611,000-square-foot Lord & Taylor flagship in New York, there's an opportunity to develop a new mixed-use project.

“There are definitely creative uses being done with all types of properties,” says Richard B. Hodos, president of New York-based retail services firm Madison HGCD. He points to epicenter, a project being developed by Gordon Group Holdings that is taking former department stores and dividing it into spaces for catalogues and online retailers that do not otherwise have large brick-and-mortar presences.

On the strip center side, after Supervalu, CVS and Cerberus Capital bought West Coast grocery chain Albertsons, the company announced that it would close 100 locations, representing about 16 percent of its property holdings. Other chains have been taking their space according to Clayton Jew, senior advisor with brokerage firm GVA Whitney Cressman. “We find that whenever an Albertsons locations comes up, we can typically find a replacement pretty easily.”

But even without selling it outright, valuable real estate can help investors to finance a portion of their purchase. They can use sale-leaseback transactions to capture the capital built up in real estate. Sale-leasebacks offer a number of advantages, including 100 percent financing, the freeing up of cash flow and the option to repurchase the stores at a future date. For example, Sun Capital Partners purchased ShopKo Stores Inc. for $1 billion in October 2005. Then, it sold most of ShopKo's real estate, encompassing 178 properties, to Spirit Finance Corp. in a $815.3 million sale-leaseback. It used the proceeds to pay $700 million in mortgage debt and a portion of the revolving credit facility.

“Financial companies tend to gravitate toward leasing the real estate rather than owning it,” says Chris Volk, president and CEO of Spirit Finance Corp. “Sale-leasebacks tend to be more efficient than straight debt, they reduce the equity requirements. And treasurers and financial investors like using them because they make their balance sheets more efficient.”

Healthy leverage

At least for now, leveraging real estate to complete a deal looks like a better bet than issuing junk bonds, which is what the raiders of the 1980s did. When Campeau bought Federated, he used 97 percent leverage, giving the balance sheet a 32:1 debt-to-equity ratio. And this was at a time of high interest rates — Federated's junk issues carried coupons of 16 percent and 17.75 percent, saddling the chain with interest payments well exceeding its cash flow.

When Apollo and NRDC bought the struggling home furnishings chain Linens ‘n Things for $1.3 billion last year, they committed to providing at least $633.4 million in equity or roughly 48 percent of the purchase price. Texas Pacific Group and Warburg Pincus paid $1.55 billion, or approximately 30 percent in equity, when they bought Neiman Marcus for $5.1 billion in May 2005. “They have more to lose if they screw up, so they will be much more conscious and conscientious in managing their money effectively,” Hooper says.

Will these investors prove to be the catalyst that beleagured retailers need?

“In retail, to effect dramatic change takes longer than a single quarter and having to report quarterly earnings under the public eye sometimes is dysfunctional,” says Bruce Cohen of Kurt Salmon. “Under private ownership, over the course of a number of years, changes can occur more smoothly, so the companies that already decided that they need to accelerate change should benefit from this environment.”

Anthony Chukumba, who follows retailers for Morningstar, agrees that the near-term focus of public markets can keep management from doing what's needed to reposition some retail chains. “When you are a public company, what Wall Street is looking for is growth, so you open more stores,” he says. “But if you go private, the investors will focus on generating cash flow and in a lot of these cases, the retailers will have to close stores. It will no longer be growth for growth's sake.”

And things get trickier when it comes to retailers who are putting themselves up for sale because they are in distress. In those cases, management often changes as private equity turns to a well-known crop of retail wizards.

Most observers believed Kohlberg Kravis Roberts, Bain Capital and Vornado Realty Trust bought Toys ‘R’ Us, for $6.6 billion in March 2005 as a real estate play. But in practice the new ownership has put a huge emphasis on reversing the retailer's flagging fortunes. They started by getting rid of excess space. In the past year, 75 of Toys ‘R’ Us’ 674 stores were closed and 12 were transformed to Babies ‘R’ Us locations.

But the company also tapped Target Corp. Vice Chairman Gerald Storch as its chairman and CEO. At Target, Storch managed supply chain operation, technology services, financial services, and Internet divisions. The company has also formed a series of new strategic partnerships to improve its logistics, and re-think its online strategy. It also hired Ron Boire, Best Buy's former global merchandising manager, to bring the chain's offerings more in line with the digital age.

“Today's seven- and eight-year-olds don't want a Barbie, they want their own cell phone,” Johnson says. “And Ron Boire brings the Best Buy experience, he was also at Sony Corp. [for 17 years], so you can be sure that's why he was brought in.”

On a less prominent scale, there's also Millard “Mickey” Drexler. Drexler, who had been CEO of Gap, Inc. for almost 20 years, and was hired by J. Crew owner Texas Pacific Group to lead the clothing retailer in a new direction in October 2002.

With a greater emphasis on product quality and the addition of beachwear, wedding attire and children's apparel lines, Drexler has been able to take the company from $768.3 million in revenue at the end of January 2004 to $804.2 million in 2005. Sales increased by 17 percent this year, from $139 million last July to $163 million a month ago.

Those are surely results his former company would love to emulate these days as it has suffered through another weak sales patch toying with old and new concepts.

Looking ahead

What's for sure is that the industry has not seen the last private equity takeover of a retailer. Such deals will continue for the balance of 2006 and probably much longer.

And most observers think owners will welcome the trend's continuation. Owners would be more than happy to see struggling retailers get a fresh start under new management. But even if things don't work out, in many cases getting the real estate back is an excellent consolation prize.

“I think the landlords are looking at this as unlocking locked-up value,” says Gene Spiegelman, executive director of retail services with Cushman & Wakefield. “They see the opportunity to remake their shopping centers, to expand the tenant mix and essentially reposition the properties to make them more effective.”

ESL Investments' buyouts of Kmart and Sears are a big reason why observers are leery of private equity takeovers of retailers.

When Lampert took control of Kmart in 2003, the retail operations had been in decline for up to three decades. Even before ESL Investments pushed the company to capitalize on its real estate assets, Kmart closed hundreds of stores and laidoff tens of thousands of employees.

Lampert, along with Martin Whitman's Third Avenue Value Fund, invested in Kmart's $1 billion debt while it was in bankruptcy. The company closed more than 600 locations, providing him with $3 billion he could use to buy Sears, Roebuck & Co. Kmart's stock shot up by more than 130 percent, but same-store sales suffered.

The combined Kmart/Sears behemoth has struggled mightily in developing a coherent retail strategy. Sears Holdings reported operating income up 4.1 percent during the second quarter — above the 2.7 percent figure from a year ago. But sales declined 3.8 percent during the same period last year, evidence that the company's fortunes have been from aggressive cost-cutting, not from improved performance, according to analysts. Net income has fallen from $1.106 billion in 2004 to $858 million last year, a decrease of more than 22 percent. Earnings per share dwindled from $11 in 2004 to $5.59 in 2005.

“With little investment in its stores, declining market share, and no clearly articulated turnaround strategy, we find it hard to believe Sears is going to stage a comeback,” writes Morningstar analyst Kimberly Picciola. “We anticipate Lampert will milk the retail business for cash and use his investing prowess to generate a return.”

Meanwhile, Sears management keeps playing with the store stock and transforming Kmart locations into new Sears locations. With the merged company's current stock of approximately 1,479 Kmart locations and 2,300 Sears outposts, Picciola expects that over the next several years Lampert will slowly sell off the chains' real estate assets, as more and more stores fail to bring in desired results. Kmart stores are generally leased and range from 80,000 square feet to 190,000 square feet. Many Sears locations, averaging from 63,000 square feet to 200,000 square feet, are owned.